One of the dramatic lessons of the recent financial crisis is that accumulations of risk in financial institutions and markets can aggravate and spread crises and lead to a severe economic downturn. In the future, if we are going to reduce the potential for financial crises, accumulations of risks that may develop to such systemic levels need to be identified early, monitored and constrained if required. Currently, the focus of such concern is Europe, where further significant deterioration of the situation will affect everybody, potentially through the financial system.
The performance of Canada's system of regulating and supervising financial institutions during the crisis has been held up as a model for others. But we must not rest on our laurels; we can do more to protect ourselves from financial contagion. Future potential financial crises will undoubtedly have different antecedents than the last one, and a so-called macro-prudential policy framework focusing on potential systemic risks can help to identify and deal with such concerns.
Macro-prudential policies include ensuring that the infrastructure of the financial system and the regulatory requirements for capital and liquidity are effective in making the system resilient to economic shocks and to contagion spreading from problems in financial institutions and markets elsewhere. Macro-prudential policies also include actions to reduce any tendency of our markets and institutions to exacerbate cyclical fluctuations in our economy and to prevent rapid expansions of credit that might lead to systemic problems.
The Bank of Canada is already monitoring systemic risks and the government has taken macro-prudential actions in response to the rapid growth of mortgage credit. What has been lacking is a formal assignment of responsibility for macro-prudential policy and a legislated framework that sets out the policy's objectives, tools and accountability.
This is particularly important in macro-prudential policy where prompt actions to moderate the accumulations of excessive risks in the financial system will only have their impact recognized well into the future when a potential crisis is avoided.
After examining a number of alternative governance arrangements for macro-prudential policy in Canada, our conclusion is that legislation should be enacted to assign formal responsibility for macro-prudential policy to a committee made up of the Governor of the Bank of Canada, the deputy minister of Finance Canada, the Superintendent of Financial Institutions and, in the absence of a national securities commission, someone nominated by the federal government to deal with potential systemic risk in securities markets. The Governor of the Bank of Canada would be the most appropriate chair of this committee.
One of the arguments that lead us to propose this committee is that the agencies led by these committee members contain extensive knowledge of potential systemic risks and expertise in using tools to counter these risks. It is important in this relatively new policy area that the governance arrangement for macro-prudential policy in Canada makes full use of this existing knowledge and expertise. As well, the governance arrangements should provide appropriate incentives to act promptly before risks have built up to serious levels that require crisis measures. The relative autonomy of this committee and the joint accountability of its members if systemic risks accumulate should provide those incentives.
Why do we need another committee? We believe that macro-prudential regulation is so important in reducing the risk of potential future crises that a formal legislated assignment of responsibility to a committee that would exist for this sole purpose is required.
Other major countries have put in place formal macro-prudential arrangements. In the United States, a Financial Stability Oversight Council has been established. In the United Kingdom, the government has created a Financial Policy Committee in the Bank of England. And in Europe, they have set up the European Systemic Risk Board. While the institutions in each of these jurisdictions may differ, there is a common view embedded in these arrangements, and in what we propose, of what constitutes a sound macro-prudential framework.
Canada needs to act soon.
Paul Jenkins and Gordon Thiessen are former senior deputy governor and governor of the Bank of Canada, respectively, and senior fellows at the C.D. Howe Institute. They are the authors of the report Reducing The Potential For Future Financial Crises: A Framework For Macro-Prudential Policy In Canada.
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